PBPB: NOT WORTHY OF THE MULTIPLE

We are adding PBPB to Hedgeye best idea list as a SHORT.

Chipotle redefined the quick-service industry with its innovative operating model, Panera created the bakery café segment and Noodles catapulted into the fragmented Asian fast casual category. All three are unique concepts that have, in a sense, redefined their respective categories.

At the heart of it, Potbelly is a single daypart, low margin, low return sub shop with declining traffic and little competitive advantage over its most basic competitors. Admittedly, these are not quite the qualities we’d expect to find in a company that is trading at a P/E of 84.3x and 21.7x EV/EBITDA on a NTM basis. But, this is precisely what we have here.

To be clear, we believe Potbelly is a solid company with a strong management team, but it should not be trading at a premium multiple to its aforementioned peers.

With that being said, we would not be surprised to see PBPB decline by 30-40% over the next twelve months.

As we wrote last week, in aggregate, the current valuations seen across the casual dining sector are shockingly high. In fact, we have no problem referring to them as bubble-like and we’ve found this extends beyond the depths of casual dining stocks to several newly minted “growth” restaurant stocks. Our CEO, Keith McCullough, did a nice job contextualizing these bubbles in this brief excerpt from yesterday’s Early Look titled “Weird Bubbles”:

From a US stock market “Style Factor” perspective, check out the score:

At least a 25% return on invested capital, as measured by the second full-year profit of new shops

Shop margins above 20%

At its core, Potbelly is a local sandwich chain competing in the most competitive segment of the restaurant industry – the sandwich segment. Although many people like to refer to it as the newest fast casual concept, the reality is it’s only at the “intersection between the fast casual and sandwich categories.” Needless to say, Potbelly’s operating model, while solid, is nothing close to jaw-dropping.

Peer Group Operating Model Comparison

Potbelly’s average unit volumes are low.

Food costs are in-line with Panera’s. There is very little room to move lower without downgrading to lower quality food.

The company appears to be very efficient, with labor costs running at 27.96%.

Other operating expenses are also very low, which could be the difference-maker in maintaining 20% store-level margins over the long haul.

Excluding IPO expenses, Potbelly’s G&A costs are running closer to 8%, which puts it fairly in-line with its competitive set.

Even after adjusting for lower G&A costs, operating margins remain low and will require sales leverage for any further upside.

Same-Store Sales

Management’s long-term guidance of “low-single digit same-store sales” implies that they believe, or want us to believe, they have the ability to take price in order to consistently drive average check higher. In fiscal 2012, Potbelly’s average check was $7, which, on the surface, appears to be in-line with other fast casual operators. With average check already at this level, relying on price as the primary driver of future profitability is a risky proposition. Needless to say, we haven’t seen anything recently that would suggest this rate of same-store sales growth will come from traffic gains. Potbelly has seen traffic decline for at least the past 3 quarters and expectations are for this trend to continue into the first half of 2014.

Average Unit Volumes

The Potbelly mission is to be “the best place for lunch.” While a strong focus on lunch is important, restaurant companies that generate the best returns operate across multiple dayparts and, in turn, generate higher average unit volumes. Depicted in the chart below, at $1.1 million, Potbelly’s average unit volumes are below all of its primary public peer competitors. Given the inherent unit economics of a Potbelly shop, we find the company’s premium multiple very difficult to justify even with the “growth” story as a backdrop.

Restaurant Level Margins

Given the rapid projected growth rate of the company, PBPB will be facing downward pressure on restaurant level margins for the foreseeable future. On average, new Potbelly shops will open up with shop level profit margins in the high-single digit or low-double digit range. It will require nearly flawless execution on store openings to avoid being stymied by incremental margin pressure.

Low Returns

Relative to its competitive peer set, PBPB generates a very low return on assets.

Strong Balance Sheet and Cash Flow

PBPB is expected to have $48.87 million of cash and short-term equivalents on its balance sheet at the end of 2013 and is expected to generate approximately $7.8 million in free cash flow after allocating $31.16 million to capital expenditures in 2014. The company has not formally announced what it will do with its excess cash, but we can safely presume they will use it to fuel their self-funding model and accelerate new unit growth in the second half of 2014 and 2015.

Valuation

Per our comments earlier and the visuals from the charts below, PBPB is a very expensive stock that we, at the very minimum, find quite unattractive from a valuation standpoint.

Conclusion

As it stands, PBPB’s operating model has little room for error. To justify the current multiple, it needs to be clear that there is significant upside from current consensus EPS estimates. We don’t anticipate this coming to fruition and, with short interest comprising 15% of the float, it appears as though we are not the only ones.

Takeaway: Chain stores posting sales growth above last year for the third week in a row. This supports the statements by many retailers about how October was the strongest month of the quarter, but has carried into November so far.

Monthly Athletic Footwear Data

Takeaway: Good month for the industry -- in line with commentary from retailers overall about October being the strongest month. Sales were up 5.7% -- balanced evenly between units and average price. Nike, Jordan and UnderArmour are the clear winners -- but stating that sounds broken record-ish. One of the real callouts for the week are VFC's footwear brands -- Vans and Timberland, which were up 20% and 16%, respectively.

"Amazon.com Inc.’s toy prices were lower than those available online from Wal-Mart Stores Inc. and Target Corp. last week as retailers seek to attract shoppers heading into the crucial holiday selling season."

"Amazon’s prices, excluding those from its third-party sellers, were 3 percent lower on average than Wal-Mart’s on a basket of 87 toys, according to a study conducted by Bloomberg Industries on Nov. 14."

"Wal-Mart’s prices were 2.4 percent lower than at Target, 5 percent less than Sears Holdings Corp.’s Kmart and 7.2 percent lower than Toys “R” Us Inc., according to the study."

"...Wal-Mart said Tuesday it will match competitors’ best Black Friday deals a week early.

At 8 a.m. on Friday, Nov. 22, Wal-Mart will cut prices on some of the most popular toys and electronics to match the best Black Friday offers from Target, Toys R’ Us and Best Buy."

"Starting Tuesday, Wal-Mart will also extend its Christmas Ad Match to online customers. Shoppers who buy an item online and find a lower in-store competitor price can recoup the difference via a Wal-Mart gift card by emailing That policy has been in place for in-store shoppers, and it runs up to Dec. 24, excluding Thanksgiving Day and Black Friday."

"Wal-Mart Stores Inc. became the first major retailer to release a large-scale audit of factories from which it sources in Bangladesh, outlining the failure and improvement rates in fire and building safety at 75 facilities. The company manufactures in more than 200 factories in Bangladesh and said it plans to publicly release results from the audits of all of the factories it uses in the country."

"Of the 75 companies in the first round of safety assessment reports made public by Wal-Mart late Sunday night, nearly 10 factories failed the initial audit, according to Wal-Mart executives. However, in a second, follow-up safety audit, 34 factories improved their initial grades from a D (a high safety risk) or C rating to an A (the lowest safety risk) or B rating."

Takeaway: Gotta hand it to WMT, they can scare the pants off of any vendor, manufacturer, or factory with the blink of an eye.

"In the latest incarnation of editorial merging with e-commerce, Men’s Wearhouse has teamed up with Esquire to launch the Esquire Ultimate Shirt and Tie Collection. The line of men’s dress shirts and ties, which sport the Esquire label, is currently rolling out to Men’s Wearhouse stores and will also be available online. The assortment, which was chosen by the editors of the magazine, retails for $79.50 for shirts and $59.50 for ties."

Takeaway: Another example of where the MW brand is headed -- on its own, without Jos. A. Bank. It's shifting to a higher-end, more aspirational mix of product to attract a better demographic. Admittedly, these changes take a looooong time to impact consumers' shopping patterns, but this strategy is definitely the right move for MW.

"TurboDown is a new technology that leverages the strengths of both science and nature, layering natural down, synthetic Omni-Heat thermal insulation, and Omni-Heat Reflective technology into every baffle. The result is an industry first, a product that has the warmth, look and feel of natural down, and performs in all conditions, wet or dry."

"Columbia's...collection will be tiered in three categories, Gold, Platinum and Diamond. And the jackets and vests will range in price from $130 to $325. TurboDown styles will be available to men and women in September of 2014 and will include 14 pieces in myriad colors and styles."

Takeaway: Let's see how long it takes COLM to sell this technology into Kohl's.

"Bangladesh garment workers took to the streets today in the Ashulia industrial zone outside of the capital Dhaka, protesting the second-lowest wages in Asia, after another demonstration yesterday left at least two dead."

"Hundreds of workers demanded a higher monthly salary of 8,000 taka ($103) today and the protests forced 50 clothing factories to suspend production, Abdus Sattar Miah, a spokesman of Industrial Police, said over the phone. A group of plant owners held a meeting with the home ministry seeking help to control the labor unrest, said Abdus Salam Murshedy, president of Exporters Association of Bangladesh."

“'We are very frustrated,' Murshedy said. 'It seems that we have to fold our business, hand over the factory keys to the government and go home.'”

Top fall trend: “Boots are stronger this year than last,” said co-founder Steve Silver. “The action is in hybrid sneaker-boots. Overall, guys have become very specific about items.”

SHOE PARLOUR, New York

Florsheim’s Indie military-inspired boot

Timberland Earthkeepers zip military boot in tan

Cole Haan’s Lunargrand wingtip on colored outsole

Top fall trend: Military-inspired boots take the top spot, said owner Abe Rogowsky, and they include pointy- and round-toe ankle versions.

CITY SOLES, Chicago

Gram’s 470G cap-toe sneaker boot in black

WESC Saddle Runar style on running outsole

Troop Vibram lace-up boot

Top fall trend: “We’re seeing a lot of military and black boots,” said owner Scott Starbuck. On the dress side, he noted young consumers gravitate toward cleaner looks. “Classic English brogues and bluchers are really trendy. There’s a [move] to quality and cleaner styling.”

LOUIE’S SHOES, Portland, Ore.

Frye Phillip harness boot

Bed Stu oxfords

Wolverine 1,000 Mile boots

Top fall trend: “Heritage brands are connecting with our customers,” said owner Pam Coven, noting authentic brands such as Frye and Wolverine. “They’re hipsters in their 30s. Younger guys like the look, too, but can’t afford the prices.”

DNA FOOTWEAR, Brooklyn, N.Y

Bed Stu Bryden boot

Wolverine 1,000 Mile boot

Red Wing Iron Ranger

Top fall trend: “Many of our best-selling brands are made in America,” said Josiane Pilon,social media and marketing manager. “The DNA man is a trendsetter and likes to wear something [he] can dress up and down at the same time, from weekday to weekend casual.”

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11/19/13 08:34 AM EST

CHART OF THE DAY: Polar Perspective

Early Look

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Polar Perspective

“Difficulties are just things to overcome, after all.”

-Ernest Shackleton

Sir Ernest Shackleton was one of the principal figures of a period known as the Heroic Age of Antarctic Exploration. Initially, this period was most identified by Roald Amundsen reaching the South Pole in December 1911. Shackleton decided to try to one up Amundsen and launched an expedition to cross Antarctica from sea-to-sea over the pole.

In 1914, Shackleton began fundraising for this “Imperial Trans-Antarctic Expedition”, which was eventually launched in September 1914 despite the outbreak of World War I. Misfortune struck Shackleton and his crew early in the trip when their ship, the Endurance, was frozen into an ice flow in the Weddell Sea. The ship eventually had to be abandoned.

For the next almost 500 days, Shackleton and his men were stranded in Antarctica. They had no contact to the outside world and routinely faced temperatures that dipped below -50 degrees Celsius. Eventually after an almost impossible trip to a nearby whaling station, the entire crew was rescued. While the expedition fell short of its goal, Shackleton and his colleagues certainly gained some polar perspective.

Back to the global macro grind...

Similarly, for many hedge fund managers this has been a year to gain perspective, if not outperformance. As an example, as of the end of October 2013 the Hennessee Hedge Fund Index was up 9.9%, which paled in comparison to the return of the SP500 of north of 23%. Now to be fair, returning close to 10% on 2 and 20 money isn’t the worst thing in the world, but undoubtedly for many underperforming a passive strategy by more than 1,000 basis points is frustrating.

Keith touched on this yesterday, but a key reason for the underperformance of hedge funds is the outperformance of heavily shorted stocks. Specifically, heavily shorted stocks are outperforming the SP500 by some 570 basis points this year. That’s enough to make any great short seller bi-polar!

Long / short equity managers likely aren’t the only investment managers going a little bi-polar this year. As an example, the PIMCO Total Return Fund has returned a capital eroding -0.87% in the year-to-date. Clearly, the big bond boys at PIMCO are having some performance issues (not to say that it would at all be easy to steward that much capital!).

The broader issue with bond managers of course is how far afield they eventually have to search for yield. Just like Shackleton and his crew in Antarctica, who eventually found land, the question for bond managers is ultimately: what is the cost of this search for yield?

As it relates to the PIMCO Total Return Fund, prospective underperformance may even be more concerning given the fund’s holdings and where the managers have gone to find yield. According to analysis by our Financials Team, almost 34% of PIMCO Total Returns holdings are in agency mortgage backed securities. In the Chart of the Day, we highlight the spread of agency MBS to the 10-year Treasury Yield. As the chart highlights, prior to the financial crisis this spread was ~126 basis points, but has now narrowed to ~68 basis points.

The almighty chase for yield has effectively priced mortgage backed securities to one of the lowest levels of risk that we’ve seen in the asset class. Even if the spread for Agency MBS just normalized by 50 basis points to pre-crisis levels, it would have a meaningful impact on the market. By our estimation, allowing for modified duration, a 50 basis increase (reversal of tapering for instance) in yield would lead to 5% downside in the Agency MBS market.

The issue for firms like PIMCO is that a 5% correction in one of its more significant asset class exposures is likely to lead to continued underperformance and accelerated outflows. Outflows and decreased liquidity, of course, are only likely to exacerbate any move in price in the MBS market.

The Financial Times this morning emphasized this point even further in an article looking at managers of collateralized loan obligations. According to the article, managers of CLOs have increased the proportion of risky loans that their investment vehicles are allowed to buy to the highest level on record. Currently, 55% of new leveraged loans come in the covenant lite form, which eclipses the 29% reached shortly before the financial crisis.

Covenant lite loans are fine, in theory, if the economy is stable, but if there is volatility in economic activity, these loans get much more difficult to repay for many corporates. A good analogy is probably Shackleton and his crew in -50 degrees Celsius weather in Antarctica. You know weather that cold is dangerous but it is survivable, until the wind starts to blow and wind chill sets in . . .

To dig further into the topics of asset allocation, our Financials Team will be hosting a call his Thursday November 21st at 11am with Carl Hess who is the global head of Towers Watson’s investment advisory services that provides asset allocation recommendations to more than $2 trillion in assets under advisement. We think this call will provide an interesting perspective on asset allocation and active management, and if you’d like details on how to get access to the call, please email .

Given the challenges faced by large asset allocation funds that rely heavily on yield for performance, going forward it might be prudent that managers of these funds search for analysts for their investment teams with a similar advertisement to what Shackleton used to find his crew:

Fed Breeding Contempt

Client Talking Points

US DOLLAR

The impact of Janet "Mother of All Doves" Yellen was precisely what it should have been on both currencies and interest rates. See Dollar Down, Rates Down with no plan to taper anytime soon. The US Dollar Index failed at our Hedgeye TREND of $81.39 which makes the EUR/USD look stronger now even though the ECB cut rates.

UST 10YR

Treasury yields sold off into and out of the Yellen Dove-Fest. Now it gets interesting as my TREND line of support is 2.63%. Resistance is 2.81%. For now, I’m looking for 2.63% to hold. So shorting Treasuries is back in my head again.

COMMODITIES

It's been just a disaster of a year for Commodities. The CRB Index hit a fresh year-to-date low yesterday down -7.8%, in spite of US Dollar weakness. After selling Gold into that Thursday Yellen bounce, my asset allocation to Commodities is back at 0%. We are short Oil too in #RealTimeAlerts.

Asset Allocation

CASH

66%

US EQUITIES

4%

INTL EQUITIES

6%

COMMODITIES

0%

FIXED INCOME

4%

INTL CURRENCIES

20%

Top Long Ideas

Company

Ticker

Sector

Duration

FXB

Our bullish call on the British Pound was borne out of our Q4 Macro themes call. We believe the health of a nation’s economy is reflected in its currency. We remain bullish on the regime change at the BOE, replacing Governor Mervyn King with Mark Carney. In its October meeting, the Bank of England voted unanimously (9-0) to keep rates on hold and the asset purchase program unchanged. If we look at the GBP/USD cross, we believe the UK’s hawkish monetary and fiscal policy should appreciate the GBP, as Bernanke/Yellen continue to burn the USD via delaying the call to taper.

WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

TROW

Financials sector senior analyst Jonathan Casteleyn continues to carry T. Rowe Price as his highest-conviction long call, based on the long-range reallocation out of bonds with investors continuing to move into stocks. T Rowe is one of the fastest growing equity asset managers and has consistently had the best performing stock funds over the past ten years.

Three for the Road

TWEET OF THE DAY

Yellen is so scary for American Purchasing Power (USD) that even the Euro hangs in post rate cut @KeithMcCullough

QUOTE OF THE DAY

Realize that if you have time to whine and complain about something then you have time to do something about it. - Anthony D'Angelo

STAT OF THE DAY

$13,000,000,000: The Justice Department and JPMorgan Chase are nearing completion of a $13 billion settlement related to the bank's past mortgage practices. A final deal is expected as soon as today.

11/19/13 08:04 AM EST

November 19, 2013

BULLISH TRENDS

BEARISH TRENDS

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